PRIVATE MARKET INSIGHTS EXPLAINER

No investor is agnostic to , and any practical approach to private equity construction must include an accurate appraisal of risk.

Standard approaches, such as the commonly-used , use the of returns to measure risk.1 The Sortino Ratio is a measure of risk-adjusted returns that instead uses downside deviation as its metric for risk, which is more appropriate for private equity.

The problem with using standard deviation is that it relies > Example of a positively-skewed distribution upon the assumption of a symmetrical return distribution. This in effect treats upside and downside equally. A portfolio with a larger proportion of higher returning assets may therefore have a higher standard deviation and erroneously appear riskier. This is true of private equity, where the distribution of returns is not typically symmetrical, exhibiting a significant positive skew (see Chart).

Positively-skewed As such, using downside deviation makes the Sortino distribution Ratio a better measure of risk for private equity, as it calculates returns in relation to the amount of bad risk assumed. Furthermore, the Sortino Ratio measures Symmetrical downside risk relative to a minimum acceptable return distribution defined by the investor. This means the risk measurement is tailored to the return an investor is actually targeting. Returns

THE SORTINO RATIO

Sortino Ratio = E [R – MAR] DD R = : the annual an investment is expected to generate. MAR = Minimum Acceptable Return: the minimum acceptable return or target against which that investment is to be assessed. DD = Target Downside Deviation: the calculation of downside risk. It is determined by first effectively eliminating positive returns from the calculation by treating them as underperformance of zero. Then you take the realized returns’ underperformance relative to the MAR and calculate their deviations. Finally, you calculate the root-mean-square of these figures.

1 n i 2 DD = √n–*∑i=1 ((min(0,x –MAR)) where xi = ith return and n = total number of returns

1 Sharpe Ratio = (Expected Return – Risk-free Rate) / Return Deviation